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Financial Regulation: Risk and Reward

Address by Governor Patrick Honohan to

International Financial Services Summit 2010

November 10 2011

The topic of this morning’s session fits nicely with what I want to say about
the way forward for the Irish banks.

To the extent that the global banking and wider financial market collapse of
late 2008 reflected both a sharp upward revision in market estimates of risk,
combined with a sharp downward movement in risk appetite, it is not
surprising that the global regulatory response has been in the direction of
seeking to shift risk to where such reassessments and changing appetites can
do less damage. That entails de-risking the banking sector (as well as
widening the scope of prudential regulation at least to some extent).

I like to list the main sources of social risk from banking as credit, liquidity
and complexity risk, as well as the constant tension of misalignment of
private incentives with social welfare. The policy responses that have been
adopted and proposed, both in international fora and in national regulatory
policies here in Ireland and in most other jurisdictions have sought to deal
with these four risk sources. For each there is a classical regulatory tool—
some dating back to the Great Depression or before—and these tools have
been intensified or ramped up where they were still in operation, dusted
down and modernized where they had fallen into disuse during the long
period of deregulation which accompanied the macroeconomic lull from the
late 1980s known as the Great Moderation.

Thus, to meet heightened credit risk, there have for years been capital
requirements; to meet liquidity risk there were liquidity ratio requirements;
to meet complexity risk there have been restrictions on scope of activity; and
to meet incentive risk there is prudential supervision.

The Basel 3 and Financial Stability Board discussions have focused on the
first two of these. The greater reliance on going concern capital instruments,
the higher overall risk-ratios, the counter-cyclical mechanisms and the more
restrictive definitions of capital all move in the direction of better absorption
of credit risk and other risks relating to asset values.

The two liquidity ratios, one to lengthen the time over which short-term
outflows can be reliably met and the other to reduce the scale of maturity
transformation on a medium-term basis, clearly roll-back the egregious
liquidity risks that were being taken four and five years ago.

Complexity risk has also been addressed in discussions that range from the
‘Volcker Rule’, seeking to prohibit own-account or proprietary trading by
regulated banks, to the suggestions from the Bank of England that narrow-
banking should form the heart of the protected and regulated banking sector.
(Complexity has not really been a major issue for the Irish banks and we
have not had to address many issues of this type outside of the export-
oriented IFSC).

Finally, intensified, intrusive supervision is on the daily agenda of every

regulator I have spoken to.

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Ireland – the problem

All of this discussion is of much more than theoretical interest in Ireland,

where it can be said that the banks as a group went into the downturn more
exposed than most other systems, and have correspondingly had to cope
with worse loan-losses than most.

The regulatory response over the past few quarters in Ireland has been fully
in line with the need to de-risk the banks and make them less vulnerable to
confidence shocks or adverse sentiment. The scale on which capital has
been replenished is very large, though the favorable impact on investor
confidence has not yet been as strong as might be hoped for. Much of the
reason for the slow return in confidence lies in the parallel weakness of the
fiscal situation – a weakness which also has its roots in the credit-driven
property bubble which lulled the managers of the public finances into a false
sense of security ending up with a tax and spending structure highly
vulnerable to the downturn.

With the government finances so stretched, the additional burden of

recapitalizing the banks has reduced fiscal headroom and contributed to the
concern of the financial markets. Still, I would like to remind you that this
recapitalization burden is often over-stated as a contributor to the required
fiscal adjustment. Indeed, the interest cost of servicing the notes injected to
recapitalize the banks only accounts for about one-tenth of the fiscal
adjustment now in prospect over the next four years.1

The plan

Since it became evident last year that heavy loan-losses were inevitable at
the banks, and that the Government was going to meet the losses arising
from the bursting of the construction and property bubble, the plan has been

1
And this is the steady state cost, which would be true even if there were no interest free period.

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to divide and conquer the risks by putting the banks – as institutions – firmly
back on their feet without being dependent on either future assistance or
threats from government; thereby freeing the government finances from the
apparent threat of bank-imposed costs.

Achieving this separation requires actions to reduce and shift risk, so that,
for example, the banks are seen to be well-capitalized and sufficiently de-
risked in terms of their loan portfolios. It also requires market participants to
be convinced that this action has been effective and sufficient. So far, not
least because of the rest of the fiscal burden remaining such a challenging
problem, investors are not yet fully convinced.

Important steps in the process are still under way but nearing completion,
namely (i) the purchases by NAMA of the big property-backed loans and (ii)
the achievement – despite the very sizable loan losses crystallized by these
purchases - of much higher capital ratios. These capital ratios are calibrated
to ensure that core tier 1 capital remains above 8 per cent through to 2012
(7 per cent equity) for the main Irish-controlled banks, taking into account
the inevitability that the non-NAMA book will incur additional losses not yet
brought to book during that time. (The new capital injected would keep the
banks above 4 per cent core tier 1 even in a severe stress scenario
contemplated by the Central Bank and involving much higher loan losses
across the loan book than are currently expected by the banks.) The higher
capital ratios have been achieved partly through the sale of sizable non-core
assets at prices above book as well as by the acquisition of equity stakes by
the National Pension Reserve Fund and (in the case of Bank of Ireland) by
the private sector.

Scale of losses dealt with by the capital injections

I’m not sure that it is widely recognized just how big the actual and
prospective loan-losses taken account of in the recapitalization of retail banks

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in Ireland has been. In fact, if we include the losses of the 6 main foreign
owned banks active in the domestic market, of which the largest have been
Ulster (an RBS subsidiary) and BOSI (a subsidiary of Lloyds) as well as all six
of the banks that were guaranteed at the end of September 2008, and if we
include all loan losses that have been provided for in the accounts of the
banks since 2007, as well as the Central Bank’s base case of the prospective
losses through to 2012 (against the expectation of which the current capital
requirements have been set), the total loan losses come to no less than €85
billion, or about 55 per cent of this year’s GDP. In addition to the State’s
share in injecting funds to meet these estimated losses (which has already
been announced and widely discussed), the remainder has in effect, been
absorbed by the shareholders. I mention this not so much to emphasize the
scale of the problem as to dispel any impression that the policy and
shareholder response in restoring capital levels might have grossly low-balled
loss estimates.

Yet investor confidence has been slow to recover fully. In part, this
doubtless reflects the conventional observation that credit and confidence are
lost quickly and recovered much more slowly. It will not have helped that the
laborious process mandated for NAMA loan valuations have taken such a long
time and that the first NAMA haircuts, high though they were, unexpectedly
proved to be less harsh on average than the rest, leading to a sequence of
bad news events. Undoubtedly, the severity of these haircuts has led some
observers to read across to the non-NAMA book (and indeed the Central
Bank has applied such a read-across on a bank-by-bank basis in respect of
the property loans in the €5-€20 million category that are no longer NAMA-
bound, and banks are being required to hold that much more capital).

A read across also from concerns in the US that American banks could
experience further loan-losses given the slow recovery of the property
market there may also have caused observers to question the adequacy of
loan-loss provisions in the Irish residential mortgage books especially given

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the downward revisions in some of the medium term macro forecasts for
employment and GDP growth in Ireland (even though the stress case
expected loss ratio to 2012 of 5 per cent used by the Central Bank for the
Irish residential loan books to determine required capital levels is well
outside historic experience in Ireland). Despite recent trends in arrears and
reschedulings, there is as yet no hard indication that the stress levels would
be exceeded. Undoubtedly there are many stressed households with
burdensome mortgage debts, not least in the buy-to-let category; the policy
challenges that this presents in terms of achieving workable and fair
solutions are more complex than the mere issue of the likely loan-losses that
might be involved, for which (as I have mentioned) an allowance well in
excess of the banks’ own accounting provisions has already been made.

Winning investor confidence

In anticipation of next year’s update of the PCAR exercise, the Central Bank
is embarking on a more granular analysis of the this part of the portfolio in
particular to track its evolving performance and determine whether the
expected loss amounts remain sufficient.

This is a long-term book and its lifetime performance will not be precisely
known for many years, nevertheless, it is important to have early awareness
as possible of any deterioration resulting from the evolving macroeconomic
conditions, and take any necessary consequential regulatory steps.

Accelerating Basel 3 agenda

As the Basel 3 programme is implemented for Ireland, both in terms of

capital and liquidity, and supported by the intensified supervision process
which we have been putting in place, the underpinnings of investor
confidence will be strengthened. Bank boards and management will be
already thinking along these lines. The faster this can be achieved, the

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better, and – though that is more easily said than done – it is clearly
desirable to aim for a earlier restoration of confidence.

Capital: Already the 7 per cent equity requirement imposed by the Central
Bank resonates with the same percentage built into Basel 3, though the Basel
definition of capital is rather more stringent. Presumably over-capitalizing
the banks would also help build confidence, but this is not something which
the State can be lightly asked to do, given the pressures on its finances.
Indeed, the market’s perception of the stressed condition of the Sovereign is
surely weighing also on the banks in terms of interest costs and ready access
to funding; just as the banking problems have weighed on the Sovereign.

Liquidity: In order to meet the Basel liquidity ratios, the banks will, over
time, have to either find new sources of long-term funding, or – more likely –
dispose of some of their assets. Packaging sizable blocks of, say, residential
mortgages and selling them to international investment funds (while
continuing to administer the loans at the retail level) is one conceivable way
of achieving the Basel long-term stable funding ratio in a way that allows the
banks to de-risk further by funding a much higher proportion of their
remaining asset portfolio with their own retail and corporate customer
deposits, and not be so dependent as they are at present on short-term
wholesale funding including central bank funding. To be sure, any such
operation would certainly have to be designed in such a way that the new
structures did not bring additional moral hazard with them. Achieving such
sales at realistic prices in the current market climate – with market
participants distrustful of all forms of Residential Mortgage Backed Security
would likely require some form of credit enhancement. As such, involvement
of external equity in such a transaction would likely be necessary.

Indeed, from a national point of view, the entry of foreign purchasers for
some or all of the banks would help transfer both credit and liquidity risk to
those in a better position to bear them. This is not as far-fetched a scenario

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as it might appear to some; astute bankers recognize that there is profitable
banking business to be done in Ireland in the years to come, though they will
differ on the optimal timing and pricing of entry.

We’ll be contributing to an intensified effort to identify viable measures along

these lines to select and implement the most cost-effective of them, as it is
clear that all will benefit from greater market confidence in the financial
situation of the banks as in the sovereign.

Towards a virtuous circle

This is a virtuous circle we are seeking to enter and exploit. Even if moving
towards a stronger banking system in terms of capital and liquidity has
entailed costly outlays for the State, it is a prerequisite for ensuring the
credit of the State.

Likewise, healthier public finances are indispensible for keeping interest costs
and ensuring that the banks have ready access to market funding. In the
end, I believe it is the prospects for effective fiscal adjustment against the
background of the global macroeconomic recovery that will most directly
determine the degree to which investors will be fully convinced that the
banks have been de-risked and strengthened in the manner envisaged by the
Basel 3 process, and thus able to contribute more effectively themselves to
the consolidation of that recovery. Besides, even if there is a negative initial
demand effect, healthy government finances are – like healthy banks –
needed for job creation and economic recovery.

ENDS

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